Month: May 2018

Much is discussed about Digital Identification, and the need to protect one’s Digital ID. Crypto Exchanges use Digital ID security measures as marketing tools versus their competition. But maybe they should be worried about losing their own identities.

I have stated a few times that the industry of crypto exchanges is following a similar trajectory to the FX brokerage industry of the last 15 years; its just happening at crypto-speed. And once again, it’s like I am seeing a remake of a movie to which I saw the original.

This time the specific nuance is that of front-end aggregation platforms. There are a growing number of firms that are making front-end trading platforms (UnionExchange, MasterDax, Terminal.Global, etc) that can hook into all of your exchange accounts (Binance, Kraken, Bitfinex, etc) and then show you aggregated liquidity, propose real-time arbitrage opportunities, or expose different volume depths. The exchange operators so far seem not to care because as they see it, they are still holding and monetizing client assets and getting the trading volume. They do not care if it is going through an intermediary platform. At the end of the day it is the trader paying the extra fees to the intermediaries. But the exchanges do not see the insidious long-term plan of these aggregation platforms.

The dominant platform in the retail FX/CFD world is the MT4 platform from a Cypriot company named, MetaQuotes. The MT4 platform rose to dominance once it was offered by a few of the largest global brokerage firms starting in 2007. The MT4 platform is just now giving way to the MT5 platform, but it is widely accepted in the industry MT4/MT5 sees 85% of retail order flow for FX/CFD’s. Similar to the current situation for exchange operators, MetaQuotes did not initially see the problem of third party application front end providers on the MT4 platform. Starting in the late 2000’s a number of application providers to the FX industry recognized MetaQuotes’ MT4 dominance and decided to integrate their front end platforms into the MT4 Manager platform (think “matching engine” in exchange terminology). For a while, all was well. These third-party applications were bringing in new traders to the FX world and volumes were improving so MetaQuotes did not mind. But when a few of the third-party applications decided to create their own back-end platform and replace the MT4 platform completely, MetaQuotes realized they had allowed these aggregation-platform intermediaries to gain a stronghold over the traders.

Retail traders do not know, understand or care about what happens on the back end. They did not even understand the terminology of the back end of a trading platform; Matching engine? Latency? API? A-Book? B-Book? Retail traders want a simple interface with their trading platform, and once they learn how to use one interface they do not want to change. This was the lesson learned from the large brokers’ failed attempts to transfer their MT4-born clients to proprietary platforms. Retail traders just knew the front end they liked and were used to. When the aggregation-platform intermediaries decided to build/buy their own matching engines, Metaquotes lost the order flow.

To their credit MetaQuotes acted decisively when they realized their vulnerability. They terminated agreements with certain third-party providers and even sued one or two in court with a lot of publicity. In the end, MetaQuotes shut down all their front-end “partners” so that traders once again would only see and use the MT4 front end platform which has allowed MetaQuotes’ dominance to continue to this day.

I expect the large crypto exchange operators will soon see the same thing happening to them. At first they will not mind these aggregation platforms as some of the downstream providers’ features will add volume to the exchanges. But as soon as one of these aggregators decides to become an exchange unto themselves and cuts the existing exchanges out of the value chain, these giants will wake up and act to take back their traders.

If you’ve ever taken an Economics class, you’ve likely heard of Nobel Prize winning economist, F.A. Hayek. In his book published in 1976, Denationalization of Money -The Argument Refined, Hayek imagines a world in which currency is not subject to the whims of government, but to that of the competitive market. To clearly explain this scenario, the economist created his own privatized currency to solve for monopolization of money by governments. In theory, the pressures of a competitive market would promote the creation of a currency with better stability and solvency than a government currency could provide.

Qiao Wang’s article shows there are clear connections between cryptocurrency and Hayek’s “Ducat” currency, particularly in reference to Stablecoins. Both Stablecoins and the “Ducat” present similar approaches to solving for stability, mainly by employing creation/redemption mechanisms via smart contracts to control for the respective currency’s deviation from its intended price. However, stability mechanisms don’t necessarily provide solvency.

If F.A. Hayek were alive today, he’d likely be intrigued with the focus of stability within cryptocurrency. Yet, Hayek’s “Ducat” had one main constraint: at any moment, “Ducat” holders would be permitted to exchange their coins for fiat at a determined fixed rate. To comply with this condition, well developed, smart monetary policy must be implemented to amass the capital necessary in the case of a wide-spread run on the currency. As it’s impossible to ensure the success of any currency, why invest if there’s no guarantee you’ll have constant access to value-storing fiat currency?

Observing the notable Stablecoins currently on the market, none have completely solved for the issue of maintaining the unrestricted ability to exchange their cryptocurrency, at a fixed rate, for fiat. Many claim their currency is a reliable, long-term store of value, but more often than not, this is only partially true.

In my opinion, there are a few reasons why many of these “Stablecoins” are susceptible to failure:

1) Stablecoins that peg their currencies to fiat currencies are invariably subject to inflation, and consequently, subject to volatility.

2) Stablecoins that depend on collateral-backed currencies (cryptocurrencies pegged to other cryptocurrencies) are subject to the volatility of that crypto-asset, which is also likely to be pegged to a fiat currency.

3) Stablecoins that mitigate currency devaluation via the issuance of value-storing entities to remove coins from the exchange, such as bonds or shares, rely on the reckless assumption that the currency will regain value. In the case that the coin is unable to recover, participants are left with unredeemable bonds and loss of capital.

4) Even if bond-utilizing coins regain value, there is no explicit pay out date for bond redemption, leaving bond holders unsure of when they’ll be refunded.

Thus, an ideal cryptocurrency would possess long-term store of value capability without pegging to a fiat currency. Fortunately, the creation of a coin which satisfies those conditions does not appear too far off.